Kroger is America’s largest grocery store operator with almost 2500 stores in the Midwest, South and West. They also own and operate about 675 convenience stores and 375 jewelry retail locations. FY 2008 saw all-time high sales of $76 billion and record earnings of $1.90/share.

Despite the poor economy Zacks is now looking for FY 2009 and 2010 earnings of $2.04 and $2.24 respectively (FY’s end January 31st of the following year).

Here are Kroger’s per share numbers from continuing operations as reported by Value Line:

FY ….... Sales …..C/F …... EPS ….. Div ….... B/V ….. Avg. P/E

2003…. 72.40 … 2.80 …. 1.16 ….. nil …..… 5.40 …… 14.3x

2004 .…77.52 … 2.77 …. 1.03 ….. nil …..… 4.86 …… 16.3x

2005 .…83.75 … 3.07 …. 1.31 ….. nil …..… 6.07 …… 14.0x

2006 .…93.77 … 3.39 …. 1.54 …..0.26 ….. 6.98 …… 14.1x

2007 ...105.94 …3.83 …. 1.69 …..0.30 ….. 7.41 …… 16.4x

2008 ...117.10 …4.15 …. 1.90 …..0.36 ….. 7.98 …… 14.1x

At this afternoons quote of $21.40 Kroger shares now trade at just 10.5x this year’s and < 9.6x next year’s estimates. Those are the lowest multiples for KR shares in almost 20 years.

Dividends were initiated in 2006 and have been increased steadily to the current rate of $0.36/year. The 1.68% current yield is better than most money market accounts are now paying.

Value Line sees Kroger as having above average safety and notes its ‘stock price stability’ and ‘earnings predictability’ percentiles as 95th and 75th (with 100th being best). Kroger’s Beta is a very low 0.65 – people gotta eat!

Morningstar is also a Kroger fan right now. They assign KR their highest, five-star rating and see ‘fair value’ as $33/share.

With today’s quote below the calendar year lows of 2007 and 2008 I don’t see a lot of downside here. A rebound to even 12 times this year’s estimate of $2.04 would bring KR shares back to $24.48 by early 2010.

Here’s a very conservative, less than seven-month play, that makes sense to me:

achieved in less than seven months on shares that only needed to go up

by 5.2% or more.

What’s the Risk?

If Kroger shares finish below $22.50 on Jan. 15, 2010:

• The $22.50 calls will expire worthless.

• The $22.50 puts will be exercised.

• You will be forced to buy another 1000 KR shares.

• You will need to lay out an additional $22,500 cash.

• You will have collected $180 in dividends.

• You will have no further option obligations.

• You will own 2000 Kroger shares and hold $180 cash.

What’s the break-even point on the whole trade?

On the first 1000 shares it’s their $21.40 purchase price less

the $1.40 /share call premium = $20.00 /share.

On the ‘put’ shares it’s the $22.50 strike price less

the $2.50 /share put premium = $20.00 /share.

Your break-even is $20 /share (excluding dividends) or $19.82 /share

including dividends.

Kroger shares could drop by as much as 7.3% without causing a loss

on this trade.

Summary:

Low-volatility, high-quality Kroger shares appear cheap by historical standards. A rebound of 5.2% or better over the next six and a half months would produce a total return of almost 30% to investors buying and writing as indicated here.

In a worst-case scenario you’d end up owning a double sized position at a net average cost of $19.82 /share. That net price would be below the lows of 2007-2008 and within 2.3% of the panic low set on March 9, 2009 when the whole market hit its final nadir.

Kroger shares actually traded at peak prices of $24.50, $31.90, $31.00 and $26.90 in 2006, 2007, 2008 and 2009 (YTD) respectively. Unless you see hidden danger lurking, this appears to be a trade with excellent risk/reward characteristics.

Comments

Supermarkets That Could Clean Up

Credit Suisse says Kroger and Safeway could see better margins.

VENDOR ALLOWANCES PLAY an important role in the food-retailing industry. While vendor promotional spending fell for most of the current decade, it is on the rise once again as brands look to drive volume. We believe vendor support will continue to increase in the near-term and see this trend as an underappreciated-positive catalyst for supermarkets and a potential headwind for food manufacturers.

Increased vendor allowances should fund pricing activity, drive better volumes, and could even help margins of food retailers. Kroger (ticker: KR) is best positioned to benefit with Safeway (SWY) a close second.

Vendor allowances represent approximately 5.5%-6.5% of supermarket sales, nearly double the industry earnings before interest and taxes margin. Vendor money is an integral business practice, as it supports a supermarket's advertising/promotional activity. Food vendors see their spending as a critical and necessary cost of doing business to ensure their products are marketed appropriately.

Vendor allowance as a percentage of sales fell almost 100 basis points from 2001 to 2008 at the major U.S. supermarkets, as robust consumer spending and commodity-driven-price increases reduced the importance of this tool. Allowances are on the rise again (up 60 basis points year-to-date in 2009), as brands look to fend off private label and reaccelerate volume growth in a weak consumer environment.

Supermarket margins have been under considerable pressure on weak volumes, deflation, and aggressive promotions, while food-manufacturer margins have improved on lower-input costs. While supermarket margins are unlikely to improve near-term, vendors are likely to use at least some of the commodity benefit to increase trade spending in an attempt to spark volume growth.

Food investors are already fully aware of the threat that a higher promotional-spending environment poses to sales growth. That said, we were surprised to see that investors largely ignored the dip into negative territory that breakfast-cereal pricing took in September, its first since 2006. Given the plethora of positive ratings on General Mills (GIS) and Kellogg (K), investors do not seem prepared for the possibility that cereal pricing could remain negative well into next year.

As the biggest buyer of most vendors' products, Wal-Mart Stores (WMT) has now begun to demand a greater share of the "soft dollars" its economies of scale provides. Raising the overall cost of doing business with Wal-Mart sounds like a negative, but it may favor big national brands with low-cost structures.

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